An Overview of Options
So, what is all this fuss about options?
Is there simply too much risk associated with trading options?
Isn't options trading only for sophisticated day traders?
What should I know about trading options or can I even do it?
Well, the trading of options is a hot topic among stock investors who may be asking the question: “Is stock investing all there is?” Do I simply buy and hope the stock goes up and sell it for a gain?
The use of options is a way of tapping into the income potential of a large universe of publicly traded stocks. If you own one of those stocks you can add to your income while waiting for it to increase in price and sell it for a gain and also possibly receive a dividend.
Let’s look at an example:
Say you decided to try your hand in the “market” and now own 100 shares of Microsoft that you purchased in April of 2017.
You bought it for $65 per share so you have $6,500 invested.
Microsoft pays a dividend of $0.39 per quarter per share so you will receive $39 per quarter for your 100 shares. But is that all you can get?
Actually, no. You can sell 1 call option contract on your 100 shares of Microsoft with an exercise price of $67.50. What that means is that you are contracting with another contract buyer (you are the seller) to sell your shares of Microsoft for $67.50 if it reaches that price by a certain time. The buyer will pay you $1.25 per contract (or $125 since 1 contract will control 100 shares of the stock) for the right to buy your Microsoft for $67.50 a month into the future. What a deal!!
What if Microsoft only gets to $66.50 by the time your contract ends? Great news ... not only do you get to keep your Microsoft shares, you get to keep the $125 the buyer gave you (called the option premium) and contract with another buyer for another period in the future, if you want.
What if Microsoft gets to $72.50 by the time your contract ends? Well, that’s not so bad either. You still get to keep the $125 option premium you received for selling the call option, but you also deliver the Microsoft shares to the option buyer for $67.50, a $250 gain on your shares. Now the downside is that you do not participate in the stock price increase above $67.50, but in this case, that is still not too bad.
You made $375 ($250 gain + $125 call premium) on your $6,500 investment in about two months. That is around a 5.8% return in a short period of time! And if you held the stock long enough to receive a dividend, then that is just more money in your pocket!
So, how can I learn more about options?
The world of options, like most pursuits, has its own set of vocabulary, so it might be a good idea to begin with some definitions.
Option - represents a contract between two investors giving the buyer rights and the seller obligations to buy or sell an underlying security. Fortunately, the buyer and seller do not have to search for each other, that is done through one’s broker and the Options Clearing Corporation.
Call - represents an option to buy an underlying security
Put - represents an option to sell an underlying security
The following table summarizes the rights and obligations of option buyers and sellers, respectively:
Exercise price - is sometimes also referred to as the strike price and represents the price at which the underlying security is traded if that price is reached on the expiration date of the contract.
Underlying security - or simply the "underlying", can be stock, a futures contract, a commodity or a cash-based index on a particular set of securities such as the S&P 500. For our purposes we will only discuss options on stock and exchange-traded funds (ETFs) and some cash-based indexes such as the SPX. In the above example, the underlying was Microsoft.
Expiration date - is the date on which the contract expires. Before that date, for American style options, exercise of the holder’s rights can occur at any time. For European style options, of which there are few, exercise can only occur on the expiration date.
Options expiration, for monthly options, is on the third Saturday of the month at noon eastern time. Therefore, for all intents and purposes, the last day to trade options on a monthly cycle is on the third Friday of the month. After the expiration date passes, the option contract ceases to exist. If the option is in-the-money then the option is either exercised or assigned. Out-of-the-money options expire worthless on their expiration date.
At-the-money - designated ATM, represent an option with an exercise price equal to the current price of the underlying.
Out-of-the-money - designated OTM, represents an option that is not in-the-money.
In-the-money - designated ITM, represents the price at which an options rights and obligations are triggered according to the following table:
Until February of 2011, options were traded with symbols containing letters designating the underlying security, the expiration month and the strike price. For instance, a Walmart January 2012 52.50 call with a regular third Friday/(Saturday) expiration would have had the following symbol: WMTAX.
Fortunately, the Options Clearing Corporation developed the Options Symbology Initiative (OSI) which provides a 21-character symbol that may be interpreted based upon the sequence of characters.
For instance, the above Walmart symbol would now be represented as follows:
WMT120121C00052500. This symbol now contains all the essential elements discussed above in the definitions.
WMT - the underlying security, Walmart (WMT)
120121 - the expiration date in YYMMDD format or 01/21/2012
C - for Call; a P would represent a Put
00052 - the dollar amount of the strike ($52)
500 - the cents amount of the strike ($.50)
A more in-depth discussion of OSI can be found on this website here and at the OCC.
Note: Unfortunately, most brokerages use some sort of hybrid OSI symbols. For uniformity, and especially if you trade across multiple brokerages, you should convert all your trades into the OSI standard in order to determine if you have wash sales across those brokerages. This can be a very daunting task.
Next Steps ...
Options are bought and sold based upon one’s price forecast of the underlying security. Strategies can be implemented using options to take advantage of the movement of the underlying and also to limit one’s risk in the position. These strategies can be graphically represented as risk rofiles. Follow that link to examine a number of the most popular option strategies.
However, options are not like stock. Options possess elements that determine their value based upon a number of factors. Those factors include:
The stock price
Exercise or strike price
Time until expiration
Whether the underlying pays a dividend
Collectively these are known as the Greeks. A good understanding of the Greeks will enhance your ability to profit more and correspondingly lose less in your option trading.